 Hello and welcome to the session in which we will discuss the concept of business income. Now what is business income? Business income is when the taxpayer engaged in a trade or a business for the purpose of making a profit. All businesses start with an idea. What is that idea? The idea is to make some profit from some skills you have. That's one way to make money. Also another way to make money is to work for a company. So if you work for a company, you're an employee, you'll get paid through a W2. As a self-employed individual, you do the work as an independent contractor or a sole proprietary. Therefore you make money separately. You make money from your own effort, not as an employee. How do you report this money? First, you would have to prepare something called a Schedule C, reporting your income along with any related business expenses and this is what a Schedule C would look like. It has a part one income and part two expenses. So let's assume for the sake of illustration, you reported gross income of $300,000 and expenses of $100,000. Well therefore you have a profit or net profit of $200,000. That's your profit from whatever business you are engaged in. Now this $200,000 is reported on Schedule 1. So we have what's called Schedule 1 and Line 3, it could be a different line in a separate year. So you report here $200,000 of income from your business income. Now you might have other business income, you add up all of your business income for the sake of illustration, let's assume that's the only income you have as additional income. So your total is $200,000, you could have more. Then this $200,000 is transferred to your $1040,000 and it's reported as $200,000. Now I'm going to have to explain something important here is notice we have adjusted gross income below the business income. So AGI, this is an important number. What I want to tell you is this, any business deduction you take here, which we'll talk about those shortly, any business deduction you take here is considered for AGI. So it's taking before you get to AGI because we have deductions that are for AGI and we're going to look at deductions later that are from AGI, from adjusted grossing. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions as well as exercises. Go ahead, start your free trial today, no obligation, no credit card required. Which will be, I'm going to just give you, plan the seed, the itemized deduction. So itemized deductions is from AGI, business expenses are for AGI so you'll take them before you get to your AGI. Let's talk about business income. Well business income is the income from the taxpayer, trade or business. It might include cash, usually that's the most common one, people pay you in cash. Or they might pay you with some sort of a property, the fair value of that property will be considered your business income, they may even provide you with a service, that's fine too. Or they might cancel your debt, that's all of these are source of income. Now bear in mind as a director or consultant and if you do work for other corporation in which you are not an employee or not employed with them, that's called self-employment income. Again self-employment income is reported as part of your income on schedule C. If you're an employee you'll get a W2, that's not what we're discussing here. You are doing work and you are getting paid independently. Also we have business expenses, it's nice to generate income without expenses, that's not reality. You incur income, you generate income but you have to incur business expenses. So which business expenses are deductible? Well the business expense has to be related to your business. It has to be in the ordinary course of business. In other words it's incurred in the normal course of business. Well for example if you are, if you're painting homes, you might have cost of goods sold, you might buy a paint, you might have supplies, you might have employees. Well those are the normal ordinary course of business. They cannot be outside your business and they have to be necessary. It means necessary means to develop and maintain your business. For example you might have to advertise, well that's necessary for that expense to be deductible. In other words you cannot just deduct any business expense, any expense and count it as a business expense because it has to be related to your business, servicing your business. So what are some common business expenses that could be included on schedule C? The big one could be cost of goods sold. If you're selling product, if you have an e-store or if you have a physical store usually that's a large expense. Salaries, wages and bonuses paid to employees, not to yourself. Usually that's a big expense if you are a service company. In other words you sell services, you need employees to sell those services. Rental expense. You might be renting machinery, equipment, office building. Now prepaid rental expense are deductible only in the tax year in which they are incurred. So prepaid later on. Commission paid to employees or others. If you have to pay any commission to get new businesses, well that's deductible. Advertising expense that's deductible. Taxes namely those accrued or paid in a trade or a business and occupational license taxes. So the taxes has to be related to your business or to obtain an occupational license. Office supplies, you might have office and you need supplies that's deductible. Expense on property and the property has to be business related, not personal property. We're going to have a separate recording, a lesson about depreciation expense which is called the cost recovery. Also business meals. What are the business meals? Those cover food and beverages consumed while traveling for business or provided to a person with whom the taxpayer reasonably expect to engage to conduct a business, a trade or a business. Now bear in mind only 50% of these expenses are allowed as a deduction because the assumption is 50% is yours and the other 50% is them. But it doesn't matter. But bear in mind that percentage could change and for 2021, the government allowed 100% for those last years. That's fine. It could change. Every time I have a year, that amount could change. The amount for that year could change in future years. Also business gifts are limited to $25 per recipient. You can give more than $25. You can give 50, whatever you want to do, but you are only allowed to deduct business gifts. For example, you want to give office peripherals, pens, pencils, t-shirts, whatever you want to do, mugs with the name of the company on it or any business gift. Well, you're limited to $25 per recipient. You can give more, but the government don't want to encourage you. This way you'll be deducting more business expenses to generate through gifts. They don't want you to do that. Bed debt expense means if someone owes you money and they cannot pay, is this deductible? Yes. It has to be worthless and actually written off. In other words, for tax purposes, you cannot estimate your bed debt expense. The bed debt expense is using the direct method. In other words, it has to happen. Any sort of insurance expense, your cars, your equipment, your machinery, any sorts of insurance, malpractice insurance, if it's related, of course, all these has to be business related. They are deductible. Automobile expense, if you're using your car to conduct business, you could either deduct the actual expense incurred, which is keep in track of your actual expenses or the standard mileage. And the standard mileage will change every year. And sometime within the same year, for example, 2022, you have two different rate, 58.5 cent per mile for the period, January till June, and 60.5 cent per mile from July till December. And so notice within 2022, they change the rate. Also we need to talk about interest business expense. That's deductible, assuming it's incurred and paid for business purposes. Now bear in mind, there's a maximum deductible allowed for interest expense on business loans. And that limit is 30% of business income, executing interest income and interest expense. We'll look at an example. Any amount of interest expense that's this allowed, it could be carried forward to future years. Now also the 30% limitation only applies to what we call large companies. What is large companies? We would look at the past three years of that company, we'd look at their gross receipt. And if it's more than 27 million, then it's considered the limitation is their subject to that limitation. If they're less than 27 million, they can deduct all their interest expense. Now bear in mind that 27 million is also subject to inflation. So in the year that you are watching this, this number could be 30 million. Let's take a look at this example. We have a sole proprietary operating a small business, took a 24-month business loan January 1st, year 4. And we have the data for year 1, 2, 3 and 4. They took the loan in year 4. The question is, can they deduct their business interest expense of 3 million in year 4? Well, what do we do? Well, we have to take the gross receipts for year 1, year 2 and year 3. And when we're looking at the gross receipt, we include interest income. We include revenues. We include both. So when we look at the average of year 1, 2 and 3, the prior three years, and we divide them by 3, we find out it's 24,816,667, which is less than 27 million. What does that mean? It means in year 4, we can deduct the full 3 million in interest expense because we are not subject to the 30% limitation. Now let's take a look at year 5. For year 5, we have to look at year 4, year 3 and year 2. When we take the average of year 4, 3 and 2, we find out that the average is 27,33,333, which is greater than 27 million. What does that mean? It means we have to compute our limitation. How do we compute the limitation? We're going to take income minus depreciation expense minus operating expense. When we are doing the 30% test, we don't include income for interest. We don't include the expense for interest. We take those two out. Now what we do is we compute this and the answer is 9,680, we're going to take 9,680, multiplied by 30%, we're good because the limit is, we are limited up to 2,009,000. We only took 2.9 million in interest expense. Now if we had interest expense happens to be 5 million for the year 5, we're only limited to 2,904,000 and the difference will be carried for future years. We need to be aware that certain expenses are not deductible on schedule C, which are charitable contribution. If you make any charitable contribution, well, can you deduct them? Not on schedule C, you might be able to deduct them on schedule A if you itemize and we'll talk about that later on. Entertainment expenses, which used to be deductible, they're no longer deductible, used to be. The personal share of state and local income taxes, that's the personal share of that. Any tax expenses for state or local for your personal income are not deducted. Personal investment interest, that's for example if you have a stug brokerage license and you borrow money to trade stocks, that's personal, not deducted on your schedule C. Stug mortgage interest, that's not deductible, the personal share of it. When the same place is used for personal and business, well, guess what, these are deductible on schedule A as itemized deduction, we have to separate them, we'll talk about that later on when we talk about schedule A. Also you cannot deduct your federal income taxes, so when you pay the taxes of the government, the federal income tax is not deductible. However, local and state income tax that are related to your business that are not personal, those are deductible, deductible under your taxes. Salaries, wages and bonuses paid to the business owner or owners, those are not expenses, those are considered withdrawals. If you pay wages to other employees, to other people, then those are deductible. Also self-employment, health insurance premium, you want health insurance, you pay the premium, those are not deductible on schedule C, they are adjustment to arrive to adjusted gross income. They are part of the adjustment to arrive, so they are for AGI to arrive to adjusted gross income. At the end, we might either have a net income or a net loss. If we have a net income, net income is subject to self-employment tax, which we'll talk about this in a separate recording. If we have a net loss, the good thing about the net loss, it might be deducted against other sources of income subject to a lot of limitation, but at least one limitation we need to be aware of is a figure limitation. The maximum business loss that an individual might deduct is 540,000 for merit filing jointly. This is the number assumed in 2022, in 2023, 25, 26, 27, that number could change for a single is 270. And any disallowed loss, you carry forward as a net operating loss. And there's a whole separate session I have about this topic because it's very important net operating loss. What should you do now? Go to Farhad Lectures and look at the additional resources through false multiple choice exercises that's going to help you the concept of business income. Invest in yourself, invest in your career, study hard, stay safe.